Your boy Nelly has long been a fan of RRSPs, even preferring them over TFSAs for a lot of people.
Basically, the logic goes like this. As long as you’re making a decent amount of money, you’ll trigger a nice immediate tax refund by investing in your RRSP. That refund can then be reinvested. If you’re in the 25% tax bracket, it’s basically like getting a 25% guaranteed return and then you get years of compounding on that return.
To really illustrate the power of this, allow me to consult my oldest and best friend, the compound interest calculator.
Reinvesting $2,500 of free money turns into an additional $16,000. All you have to do to make that money appear is to reinvest your tax refund, which you only got from contributing to your RRSP in the first place. It’s truly amazing.
If you do this for a decade you can really see how immediately reinvesting that tax refund starts to add up. All it takes is a 10-15 years of investing a decent amount when you’re young to ensure there’s enough for retirement.
But we often forget about what happens once you hit retirement age. That cash has to be taken out, which becomes a problem if you’ve got a mil or two sitting there. Not a big problem, mind you, but a problem nonetheless. Just how can you deplete your RRSPs without paying a boatload of tax?
I’ve been thinking about this lately. I first started contributing to my RRSP as a slightly chubby 15-year-old flush with cash from my first job. That contribution was approximately $500 and God does that make me feel old today.
Surprisingly, the 15-year-old ladies of 1998 were not impressed with my savings ability. It’s okay though; they’re all clearly lesbians.
Remember, there were no TFSAs back then. So I continued to contribute despite not having much of a tax liability. I consistently put money away over the years to the point where I’m now sitting on some pretty solid RRSP assets.
I’ve crunched the numbers and if I compound these assets at 8% for the next 30 years — which is when I’ll hit the traditional retirement age — I’ll have well over $1 million in just RRSPs alone. I should also have another $1 million from my TFSA, which I plan to max out annually for as long as I can.
I’ve also got stocks and other investments outside of these registered accounts.
So what’s a guy to do?
The problem with all this is I’m looking at big tax bills when I hit age 65. I guess I can delay it until age 71, when I’ll be forced to contribute 4% of the portfolio.
Say it’s worth $1 million even. I’ll have to withdraw $40,000 per year that first year and then even more going forward. If I have a portfolio spinning out lots of tax-efficient dividend income (which is the plan). I add the $40,000 per year — which is fully taxable — to say $50,000 in dividend income and I’m looking at a relatively high tax rate.
And that’s assuming I only get $50,000 in annual dividend income. Considering our savings rate today and having 30 years of growth ahead of us we could easily have $150,000 to $200,000 in household dividend income by the time I hit retirement age.
It was valuable to me to defer tax when I was younger. But the more I look at it the more I realize deferring tax is no longer the right answer for me. I will likely only contribute during heavier taxed years going forward, choosing instead to channel savings into my TFSA and taxable accounts.
Yes, you can oversave for retirement
Is oversave one word or two? Screw it, I’m going with one. Even if Google doesn’t agree with me.
Somebody who blindly invests the maximum into their RRSP for their entire 45 year working life is doing it wrong, IMO. They’re going to end up with a massive amount of money set aside that’ll all have to be withdrawn at a high tax rate.
The better strategy is to end up with a moderate amount in your RRSP and go nuts maxing out your TFSA.
But at the same time, this only really applies to the very small percentage of the population that has consistently maxed out their RRSPs as a young person. If you’re 40 and are sitting with $25,000 in your RRSPs ignore this whole post and put in as much money as you can afford. Your problem is saving enough for retirement, not avoiding tax caused by oversaving.
Essentially, I’m getting close to oversaving for my retirement. If I don’t settle down on the RRSPs I’ll have a big tax bill when I get older. I’m the first to admit this is the very epitome of first world problems, but it’s still something I’d like to avoid.